June 2012 Futures and OTC Clearing

Moving Into the Mainstream: Liquid CTA/Macro Strategies & Their Role in Providing Portfolio Diversification

A Prime Finance Business Advisory Services Publication Methodology Table of Contents

Key Findings 4

Methodology 6

Introduction 7

Section One: CTA/Macro Strategies Emerge as a Key Portfolio Diversifier 8

Section Two: Growing Sophistication of Systematic Trading Prompts Major Industry Realignment 19

Section Three: Layered Distribution Approaches Offer Diversified Options for Accessing Capital 30

Conclusion 42

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 3 Key Findings

Investors’ interest in Liquid Commodity Trading Advisor (CTA)/Macro strategies accelerated sharply after the 2008 Global Financial Crisis, as these managers’ outperformed long-only and hedge fund strategies and provided a ready source of liquidity to cash-strapped investors. This was broadly cited as the “2008 Effect”.

• Managed Futures assets under management (AUM) grew There has been a decisive shift within the Liquid CTA/ 52% between the end of 2007 and 2011 . Hedge fund Macro manager landscape toward systematic as opposed to industry AUM grew only 5% in that corresponding period.1 discretionary trading. Whereas AUM was fairly evenly split between these two approaches in 2000 (55% systematic and • Managed Futures increased market share as a result, rising 45% discretionary),that ratio changed dramatically to 83% from 10% of combined industry AUM in 2007 to 14% by the systematic and 17% discretionary by the end of 2011.2 end of 2011. • Most of the exchange trading pits have become electronic • The inclusion of Liquid CTA/Macro managers in investor in the past decade, and the number of floor traders has portfolios reflects rising conviction that these managers offer dwindled significantly. This removed a ready talent pool important diversification benefits by being uncorrelated to from which many of the industry’s leading discretionary other asset classes and by being well positioned to generate traders originated. Most emerging managers do not have returns during unusually volatile periods. any specific sector affiliations. • Interest from institutional investors has been particularly • Improved technologies have resulted in widespread notable, and increased allocations from these participants availability of modeling tools and readier access to are driving many of the largest Liquid CTA/Macro managers exchange price data. This has allowed a broader set of to reduce their volatility and target more modest returns—a participants to develop systems, whereas in the industry’s dramatic change from the early years of the managed early history those traders needed to be affiliated with a futures industry when these strategies were seen as major firm that had mainframes for evaluating data and “high octane”. programmers to write query routines. Liquid CTA/Macro strategies are seen as a distinct category • The rise of electronic trading not only facilitated more from both traditional long-only portfolio managers and from readily available price data, it also allowed for an Global Macro hedge fund managers because of differences in explosion in the number of futures contracts. According their investment approach and the products they trade. to the Futures Industry Association (FIA), between 1994 • Trading styles in the Liquid CTA/Macro space span both and 2011, the number of distinct futures contracts discretionary and systematic approaches, in contrast to (excluding single stock futures) rose from 273 to 1,262. long-only funds that trade on a value-based approach and This created a larger opportunity pool for systematic Global Macro hedge funds that adopt a more thematic traders to test models and made it easier for them to get investment principle. orders to those markets. • Liquid CTA/Macro strategies focus their investment capital solely in exchange-traded futures and options markets or in OTC currency markets. They do not trade securities, nor do they include OTC swap products in their portfolios. • The number of markets included in the investment portfolio of Liquid CTA/Macro managers is also much broader than either long-only or Global Macro traders. Oftentimes, Liquid CTA/Macro participants may be actively engaged in 100 or more markets as they seek out the necessary depth and diversity to support their investment approach.

Source: 1-2. BarclayHedge

4 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification The types of systems being deployed within the Liquid Distribution models used to raise capital for Liquid / CTA CTA/Macro space have also changed dramatically. There has Macro managers have become highly diversified, with been significant expansion in the number of models being different approaches for retail participants as opposed to used to evaluate opportunities, a dramatic shortening of the high net worth and institutional participants. time frame under consideration, and broad growth in the • The roots of the Liquid CTA/Macro landscape originated number of markets being tracked. This has resulted in distinct with the wire or brokerage houses that offered managed “generations” of systematic approaches. futures product to retail market participants. This model • Generation One systems were primarily long-term trend- continues to the present and is slowly being augmented following systems that used breakouts as a position by expanded opportunities in the regulated fund space via generation signal. These systems were originally focused ETFs, 40 Act alternative funds, and UCITS funds. in the traditional commodity markets. • Capital-raising platforms emerged in the mid-2000s to • Generation Two systems moved the focus from “the” model target the high net worth and emerging institutional to a set of models—some used for pattern recognition and investor. These platforms provided an opportunity for some for signal generation. The types of signals also investors to direct money toward specific managers expanded from breakouts only to a broader set of measures either directly or via swap. In recent years, the original that included mean reversion, momentum, volatility, and “shopping mall” model for these platforms has converted others. These more mathematical calculations allowed to expert-driven platforms where either fund of participants to look at ever shorter time frames and funds or third parties take on more responsibility for supported a shift from long-term to medium-term and portfolio construction. short-term systems. This shift also coincided with a move • Many of the largest managers are also building out from commodity-focused markets to a broader set of their ability to directly market to high net worth and financial and currency contracts. institutional investors either via comingled funds or • Generation Three systems expanded the sets of models through separately managed accounts that sit on different, even further, adding transition evaluation models that kick operational platforms. in after pattern recognition and signal generation models. This latest generation of systems also experiment with new types of models that translate prices in one market into alternative measures or use signals in one market to establish positions in equivalent markets. The other key characteristic is that there will often be multiple models running in the same market which may be prompting conflicting signals that need to be netted or managed.

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 5 Methodology

This paper is the result of a series of qualitative interviews conducted with an audience of CTAs and hedge fund managers focused on highly liquid macro strategies as well as investors and other participants involved with allocating to these strategies. These participants, drawn broadly across the CTA / Managed Futures and investor landscape, were surveyed to discuss the history and evolution of their organizations, determine key trends that have emerged since 2008, and gain insight into factors shaping the industry’s future.

Our Futures Research and Business Advisory teams Profile of Survey Respondents interviewed 42 CTAs and hedge fund managers focused on liquid strategies, marketers, pension plans, fund of funds, and consultants globally. In total, the participants represented AUM of $86.5 billion USD, just over 25% of the industry’s total allocations.

These interviews were not scripted, nor did they entail having participants fill out multiple choice questionnaires; instead, they were free-flowing interviews focused on understanding the perspectives and current trends observed by the participants. In total, we have drawn the conclusions in this report from more than 40 hours of dialog.

We have selected key quotes from these interviews to highlight important themes mentioned by CTAs and investors in order to capture the “voice of the client.” These quotes have been included on an unattributed basis, as participation in this survey was done confidentially and we have determined not to reveal either the firms or individuals who contributed to Source: Citi Prime Finance & Futures the report. The breakdown of participant by type, however, is highlighted below.

6 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Methodology Introduction

A significant shift in approach has taken place since the 2008 Global Financial Crisis and investors, particularly institutional investors, have been actively looking to diversify their portfolios to better weather periods of unusual market stress. Liquid CTA/Macro managers have been the beneficiary of this trend as demonstrated by rising AUM and market share. Citi Futures & Prime Finance is committed to this space and is actively working to support our portfolio of managers and facilitate increased understanding of these strategies for our investor base.

One goal of this report is to help investors understand the Finally, the report will examine the unusual nature of the nature of these managers and why their portfolios provide Liquid CTA/Macro client base and how this has resulted diversified returns relative to other investment options. In in a multichannel distribution model. Unlike many other particular, it will be important to understand why Liquid investment products that are designed either for retail or CTA/Macro managers differ from hedge funds, particularly for high net worth/ institutional audiences, Liquid Global Macro hedge funds, since investors often look at CTA/Macro funds offer a regulated product that appeals to these investments side by side for allocations from their both audience sets. alternatives buckets. As a result, the industry has seen several new distribution Another goal of the report is to understand how the Liquid models emerge to augment the original wire house managed CTA/Macro industry itself has evolved. There are divergent fund product. New distribution platforms and direct marketing styles of trading in this space—discretionary and systematic. from the larger firms are broadening the investor base. Even Although there was a fairly even split between these two more change could be pending as market participants look approaches during the first 20 years of the industry’s history, toward the potential of new structures like commodity ETFs, the focus has shifted decisively toward systematic trading 40 Act alternative funds, and UCITS funds. over the past decade.

It is important to understand how enhancements in technology and the decline of floor-based in favor of electronic execution at the major exchanges have driven this change in approach. These forces represent foundational changes in the industry that are likely to shape how Liquid CTA/Macro participants approach investing for the foreseeable future.

These trends are not only driving the industry to be more systematic, but they are also changing the nature of the systems being deployed by participants and allowing for increasingly dynamic and innovative trading models. Tracking this evolution will help investors understand the range of systematic programs available in the Liquid CTA/Macro space, and determine how different generations of these systems may be positioned in their portfolios.

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 7 Section One: CTA/Macro Strategies Emerge as a Key Portfolio Diversifier

Investors’ focus on Commodity Trading Advisors (CTAs) and on currency focused Macro hedge funds has accelerated in recent years, particularly after the 2008 Global Financial Crisis when these managers outperformed many traditional and hedge fund manager portfolios. Assets under management in the space are growing quickly and represent a rising share of total alternative allocations. Institutional investors in particular are beginning to focus on these investments as important diversifiers for their overall portfolios.

What is a CTA? CTAs Offer Distinct Portfolio Characteristics

Formally, a CTA is defined as an individual or a firm registered One of the primary distinguishing factors of CTAs is the with the Commodity Futures Trading Commission (CFTC) that products in which they trade. It is difficult to overemphasize receives compensation for giving “advice” on futures, options, the futures-centricity of CTAs. They trade almost exclusively and the actual trading of managed futures. in highly liquid, regulated, exchange-traded instruments found on futures and options exchanges or in deep over-the-counter Registration for CTAs is done through the National Futures (OTC) currency markets. The futures markets encompass Association (NFA) and is required for any individual or firm commodity, interest rate, currency, and equity index futures profiting from the advice they provide, unless they have not and other products – housing prices, weather, etc. provided more than 15 persons with such advice over the last year and they do not advertise themselves as a CTA. They must This means that CTAs operate primarily in the regulated be registered before presenting themselves to the public as domain. Along with the regulatory oversight demanded by money managers. However, there is no required registration the country in which the CTA intends to distribute its fund, if the individual or firm is a registered investment advisor with its primary holdings – futures contracts – are subject to the the U.S. Securities and Exchange Commission (SEC) and only regulatory regimen of the exchanges on which they trade. provides futures and options advice incidentally. This means that there is complete transparency into the The registration process is complicated, with advisors having to markets where CTAs operate. All futures contracts are settled go through a deep Federal Bureau of Investigation background daily, and the CTAs’ holdings are marked-to-market. This check and provide significant disclosure documentation when enables CTAs to report their funds’ value to investors daily first registering and then being required to provide updated and based on recent technology enhancements, even allowing information on a regular basis (currently every 9 nine months) managers or the exchanges to assess portfolios intraday when to the NFA for review. market conditions warrant.

Firms outside the U.S. do not need to register as a CTA if they Along with marking-to-market, futures positions are, for the both fall under the jurisdiction of a comparable regulatory most part, readily reversed, adding to the high degree of body and they have an appointed “agent” in the U.S. to liquidity which characterizes CTAs. An important feature of market on their behalf. While not an official term for such the CTA offering is the manager’s ability to provide greater managers, many of those we interviewed for our report that flexibility to investors on liquidity terms. Many CTAs offer reside outside the U.S. and are not registered continue to use immediate, or nearly immediate, redemption features to the term CTA more broadly to discuss a category of managers clients – in large part because their futures holdings permit that employ similar techniques in similar markets whether or them to quickly reverse positions in most market conditions. not officially registered as a CTA. Another factor distinguishing CTA portfolios is the expanse of markets across which they trade. Many of the participants in our survey noted that their portfolios span 100 or more markets across the globe. The ability of CTAs to look across such a broad opportunity pool is linked to active growth in the number of exchanges and contracts in recent years.

A final distinguishing factor for CTA portfolios is the instruments in which they do not trade. Unlike traditional or hedge fund managers, CTAs do not put securities or OTC derivative positions in their portfolios.

8 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Section One: CTA/Macro Strategies Emerge as a Key Portfolio Diversifier We have also opted to include a certain subset of hedge fund Chart 1: Liquid CTA/Macro Landscape managers in this report. These hedge fund managers trade exclusively in the currency markets. Their portfolios mimic the same characteristics as a CTA portfolio. They trade only in highly liquid currency markets and do not have any fully paid or margined securities in their portfolios (other than for funding purposes), nor do they have any OTC derivative swap positions. They trade across a large number of markets to achieve diversity in their portfolios. They also offer highly liquid investor terms.

For this reason, we have chosen to include their views in this study and classify them broadly as part of the CTA universe. We will therefore refer to this combined audience going forward as the Liquid CTA/Macro subset. The full set of managers in this subset is listed in Chart 1.

Source: Citi Prime Finance & Futures

“ CTA started as a regulatory term. What does it even mean “ The biggest market development in recent years has been the anymore? The C doesn’t even have meaning for a bond guy. increased liquidity and number of markets. In our approach, The term I use is tactical strategies. This classification contains we are always trying to increase the number of markets what we typically call CTAs, global macro, macro & FX. Any we trade for diversification. When we launched, we traded strategy that uses liquid OTC instruments or exchange-traded 50-60 markets. Now we trade a global futures portfolio of over instruments that are not a bond or a stock,” 180 markets,”

– CTA-Focused Fund of Fund – $1-$5B CTA

“ We are very strong around liquidity and transparency. “ I almost always present FX as a part of CTA and investors We provide views of our holdings on a daily basis and we offer almost never push back. If you say that a systematic CTA with daily liquidity,” an intermediate to long-term model is generating trades in – >$5B Currency Hedge Fund futures markets, what’s important is how they are generating trades. They are generating trading signals on trend-focused “ We want investors that are aligned with us. We require one markets. If that signal is being generated in an FX market, month notice in our documents, but if you’re not comfortable there is no real difference,” with us, we can get you out in 24 hours,” – CTA-Focused Fund of Fund – <$100M CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 9 against their securities via margin loans or repo transactions. “ We tend to be more diversified than most big macro name If they go short equities, they need to perform a “locate” hedge funds. Our Systematic trading approach is very different ahead of establishing a short position and then “borrow” the from a fundamental approach. We’ll be trading currencies security they’ve shorted within a narrow time frame. and interest rates and bonds like a macro fund, but we’ll In contrast, Liquid CTA/Macro traders buy standardized and also be trading other weird small esoteric markets like rubber OTC contracts on “margin” by posting a percentage of the or sugar,” contract’s total value with the exchange. This margin rate is – $1-$5B CTA determined by the exchange and is standard for all industry participants. Moreover, both long and short exposures are “ We have global exposure and we’re trading macro products, considered equally by the exchanges and there is no process but it’s very different. Our approach is math-based. It’s not difference in the establishment, maintenance, or liquidation of opinion or report-based. It’s about volatility and momentum. these positions. We’re looking at charts and they’re looking at names,” Another difference between the participants is that – $100-$500M CTA Global Macro hedge fund managers will only offer limited transparency into their comingled investment portfolios because many of their investments may be in bespoke or Liquid CTA/Macro Traders Differ from thinly traded instruments. They do not post a daily mark-to- Global Macro Hedge Funds market that allows their investors to track the fund’s value, CTAs and Global Macro hedge funds share similar investment although the manager’s prime brokers evaluate their margin goals, but the nature of their “bets” is different. Liquid CTA/ exposure and collateral coverage daily. Macro managers will either approach the markets from a discretionary basis, where they use their expertise in a specific sector to recognize intra-market opportunities, or from a “ Global Macro aims at buying at the bottom and selling at the systematic basis, where they use mathematically driven top and so are we, but we don’t try to anticipate. We only models to generate trading signals based on price patterns. buy when the bottom has been made. We don’t anticipate, period,” Most Global Macro hedge funds are thematic. They will look to identify broad trends and assess how those trends will affect – $100-$500M CTA a broad set of countries, markets, and assets. They make this assessment by looking at the countries affected, their major “ Many global macro traders have embedded biases just industrial sectors, raw materials they import and export, and like many other long/short or long-only managers. If you the impact of politics and economic policies. They will then compare their returns to certain indices, their correlation think about how to establish positions across the capital never changes. They are always long commodities. They are structure of impacted equity and bond sectors and in the always long Emerging Markets. If you’re in normal conditions, futures and currencies markets that relate to those countries those strategies do fine, but in more volatile conditions, their and their trade flows. inability to be tactical and adapt shows through,” – $1-$5B CTA Given this thematic approach, Global Macro hedge funds offer up a very different investment profile than the Liquid CTA/

Macro portfolios discussed earlier. While Global Macro hedge Finally, Global Macro hedge funds typically have much more funds employ futures and options and may even trade in liquid restrictive lock-up and redemption terms than Liquid CTA/ currency markets, they predominantly express their market Macro funds. Global Macro hedge funds usually require views by establishing long and short positions in equity and monthly or quarterly notice from investors to redeem bond securities. They will also establish swap positions to funds and then only allow quarterly or annual redemptions, create synthetic access to a market or to hedge unintended sometimes choosing to impose investor gates that limit the interest rate or credit exposures. Many Global Macro hedge portion of their investment that they can withdraw in any funds may also look to invest in hard assets—taking stakes in given redemption period. actual production facilities such as copper or gold mines. For all these reasons, we have opted to exclude Global Macro The mechanics of their trading are also different. Global managers as part of this survey. This difference is highlighted Macro traders employ leverage in their portfolios by borrowing in Chart 2.

10 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification

Chart 2: Comparison of CTA and Global Macro Funds

Source: Citi Prime Finance & Futures

Assets in Liquid CTA/ Macro Strategies Chart 3: Growth in CTA AUM Are Growing Rapidly

According to BarclayHedge, AUM in the liquid CTA/Macro space reached a record $314.7 billion USD by the end of 2011. This represents nearly a 10x expansion in the overall size of the industry since 2000, when assets were only $37.9 billion USD as illustrated in Chart 3.

Source: BarclayHedge

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 11 The rapid expansion in the industry over the past decade much AUM before becoming too large to effectively move into has marked a major shift in the profile of the liquid CTA/ and out of positions without disrupting market activity. Macro space. It took nearly 20 years from the inception of As the number of markets in the U.S. and abroad began to tracking managed futures industry assets in 1980 for AUM expand, managers realized that they could broaden their to surpass the $40 billion USD mark, but in recent years the portfolios and thus absorb much larger amounts of AUM than pace of growth has accelerated dramatically. One reason previously anticipated. This allowed them to expand their for the increase has been the explosion in the number of marketing efforts and focus on a broader array of clients. exchanges and contracts where Liquid CTA/Macro traders Several managers who now have several billion dollars in AUM can participate. noted that back in the late 1990s, they had thought their total According to the FIA, from a notional $2.2 trillion USD at capacity was no more than $1.0 billion USD. the end of 1998, global turnover of futures and options had increased by 2010 to more than $22 trillion USD. In that same Chart 4: Number of Futures and Options period, fierce competition among exchanges has led to an Contracts: 1994 vs. 2011 enormous increase in the kinds of futures traded.

Chart 4 illustrates that the number of distinct futures contracts traded has expanded from 273 in 1994 to 1,262 at the end of 2011 (excluding single stock futures). In that same period, the number of U.S.- based futures contracts increased 5x from 93 to 520 and non-U.S.-based futures products increased 4x from 180 to 742 contracts. Simultaneously, the number of options contracts globally grew from 150 to 404 contracts.

The explosion in the number of contracts has provided Liquid CTA/Macro managers a fertile landscape for growing their portfolios. Many of the more established managers interviewed for the survey noted that their perceptions about how much capacity their strategies could support changed dramatically between the 1990s and the past decade. For many years, there was a sense within the Liquid CTA/Macro community that any individual manager could only absorb so Source: Futures Industry Association

“ We did research back in 1997 sizing the market and we thought “ We were trading in 80-90 markets in 2000. We added another we wouldn’t be able to get our AUM above $1.0 billion. We’ve 20-25 a couple years ago. We are constantly looking at new realized subsequently that futures are actually much bigger markets. Some of our peers will cite a much larger number and able to absorb much more,” of markets that they trade in because they are counting – >$5B CTA single swaps or synthetic exposure and we don’t. It has to be meaningful to the portfolio. It has to have enough liquidity,” “ A lot of CTAs that started around the time we did in the – >$5B CTA late 1990s and before had smaller estimates on what they

could manage and they’ve all subsequently increased “ The biggest market development in recent years has been the their estimates,” increased liquidity and number of markets. In our approach, – $1-$5B CTA we are always trying to increase the number of markets we “ We look at 120 exchange-traded markets, some of which are trade for diversification. When we launched, we traded very small markets like red soybeans in Tokyo or cocoa. We 50-60 markets. Now we trade a global futures portfolio of over have to be careful. We can’t step into those markets with size. 180 markets,” We’d kill it. If you look at a market like bonds, we’d be only a blip – $1-$5B CTA on the radar,” – >$5B CTA

12 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Another factor driving growth in AUM has been growing interest from institutional investors. Many institutional “ 99.9% of everything does really well in risk-seeking periods participants (particularly pension funds) had been heavily and really poorly in risk-averse periods. Our first mandate as invested in equity markets in the period running up to the a CTA is to be an absolute return strategy, probably a portfolio technology bubble in 2000. These participants suffered heavy hedge in our investor’s book. Our second mandate is to losses in the aftermath of market declines in that period, and make money in risk averse periods when everyone else is were left with liability gaps that prompted them to rethink doing poorly,” their portfolio approach. – $500m-$1.0b CTA Many of these institutional participants observed that leading endowments that had diversified their portfolios more heavily “ We don’t fall into the group that’s looking at CTAs for their into alternative investments outperformed in this period, as tail hedge during crisis periods because sometimes they their investments were less correlated to the major stock and are well positioned to capture the tail and sometimes bond market indices. This led to a shift in institutional they’re not. We look at CTAs for them being uncorrelated to our other managers,” – Fund of Fund with CTA/Macro Sleeve Chart 5: Relative Returns During Calendar Year 2008 portfolio construction from an asset class-driven allocation to a “portable alpha” approach that increased the percentage of portfolio assets devoted to absolute return and uncorrelated strategies. This resulted in a wave of institutional investment interest into hedge funds, private equity funds, and Liquid CTA/Macro managers.

Early pioneers into the Liquid CTA/Macro space were soon joined by a second wave of institutional investors after the 2008 Global Financial Crisis.

“2008 Effect” Drives Major Reassessment of Liquid CTA/Macro Strategies

Performance during the 2008 Global Financial Crisis proved to be a watershed moment for the Liquid CTA/Macro fund community. Indeed, the impact was so great that many of our Source: HFR, BarclayHedge MSCI, S&P, Citi interviewees attribute expanded interest in these strategies in recent years to the “2008 Effect”.

There were three aspects of Liquid CTA/Macro performance “ Recent years have helped to really drive home the concept of that have led to this paradigm shift in the view about being diversified. Don’t try to be too smart about it and time these managers. things too much. Just be diversified,” Foremost was their ability to show that they offered – $100m-$500m CTA uncorrelated market returns as shown in Chart 5. For the “ 90% of the interest in making increased allocations to the CTA calendar year 2008, the MSCI Global Equity Index was down space is being driven by the lack of correlation demonstrated 40.3%; the S&P 500 was down 37.0%; the Citi U.S. Broad to the major asset classes,” Investment Grade bond index (USBIG) was up 7.0%; and the – $500m-$1.0b CTA HFI Global Hedge Fund Index was down 6.85%. By contrast, the HFRI Systematic Diversified Index that tracks many of “ There’s lots of studies showing that commodities are not the systematic CTA/Macro traders was up 17.2% and the correlated to stocks. They trade much differently due to the BarclayHedge Discretionary traders index was up 12.2%. For long and short nature of commodities,” many institutional participants, having some exposure to – $1.0b-$5.0b CTA Liquid CTA/Macro strategies were now viewed as a necessary

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 13 diversification option for their portfolios to provide a tail-risk hedge for unanticipated stress periods. “ 2008 was a big watershed. It has upped the level of demand Beyond offering better returns, Liquid CTA/Macro from investors for CTAs,” managers also provided another critical benefit during that – $1-$5B CTA period—liquidity. “ 2008 really underscored to people that we are an One of the most commonly used refrains emerging from our “uncorrelation” play to hedge funds,” series of interviews for this survey was a reference to the – $1-$5B CTA Liquid CTA/Macro funds ability to act as an “ATM” for the industry during the previous crisis. Many investors were “ 2008 helped. Prior to 2008, everyone was afraid of managed desperate to generate cash in that period, particularly those futures. They were too risky, too scary, too complicated. that had money invested directly with hedge funds or in fund People were educated about stocks. They were educated of hedge funds, where many managers opted to impose gates about bonds. In 2008, managed futures did really well and that prevented investors from withdrawing assets; these now pension funds and institutional investors are starting to managers realized that there were misalignments between show interest in the space,” the actual and promised liquidity of assets in their portfolios. – $100-$500M CTA In contrast, Liquid CTA/Macro funds were able to easily exit positions and generate cash. They were thus seen as an important source of capital for investors looking to generate Many investors who were unable to exit their hedge fund cash during that time frame. Indeed, the demand for capital and fund of hedge fund holdings were shocked to find out was so great that even top-performing Liquid CTA/Macro fund the types of assets being held in those portfolios. Many of managers were subject to substantial withdrawals, as cash- these investors found out that their capital had been used to strapped investors sought funds through any liquid portal. purchase assets as diverse as airplanes, mines, and production This provision of liquidity was important for both the small facilities, even though in many instances these types of and large investor. investments had not been discussed as part of the hedge fund The third factor that impacted investor perceptions of Liquid manager’s investment approach. CTA/Macro fund managers was the contrast they provided to Surprise at the holdings in these portfolios was to be expected. hedge funds in terms of their ability to provide transparency Hedge fund managers have traditionally been reticent to into their portfolio holdings. share information, especially prior to the 2008 crisis, and many institutional investors had adopted a “leave it to the professionals” attitude about understanding the exact nature “ We’re 1 month in and out, no lock-ups or commitments. There of their manager’s approach and portfolio holdings. are advantages and disadvantages to this. In 2008, those folks While hedge funds’ willingness to provide information has with lock-ups locked their clients and held onto that money. improved post-2008, there is still a lot of tension between We didn’t. There were lot of funds people wanted to get out of investors and hedge fund managers regarding how much that they couldn’t so they got out of us,” transparency should be provided into the portfolio. This has – $100-$500M CTA raised investor appreciation for the full transparency Liquid CTA/Macro funds offer. “ We were pretty much used as an ATM in 2008 because of our liberal liquidity,” Moreover, lessons learned in 2008 have prompted nearly – $1-$5B CTA all investors to adopt a more proactive and informed stance with regards to ensuring their own understanding of the “ What we saw in 2008 which was really frustrating was that investments in their portfolio. Improved knowledge about the in the 4th quarter we were up 20% but lost half our assets types of investment strategies available to them has resulted because of the liquidity. If people were facing losses elsewhere in many more investors now looking at Liquid CTA/Macro or margin calls elsewhere, they will take money out of CTAs funds for the first time. because we can liquidate them,” – >$5B CTA

14 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Liquid CTA/Macro Funds Gain Market Share Chart 7: Comparison of CTA Returns from Hedge Funds & Major Industry Benchmarks As investors become more familiar with the profile of Liquid CTA/Macro funds, their interest in these strategies is rising. Changes in overall AUM levels post-2008 also indicate that a portion of the capital directed to the space is being diverted from more traditional hedge fund investments.

While Liquid CTA/Macro strategies accounted for only 7% of the combined pool of assets in 2000, that figure has risen to 14% by 2011 as shown in Chart 6. The acceleration of gains post-2008 is quite clear and continues to the present.

The trend toward increasing allocations was already underway prior to 2008; however, gains since the Global Financial Crisis represent an acceleration of interest. What became clear through the interviews is that this trend is being driven by investor desire to create resiliency in their portfolios by using Liquid CTA/Macro strategies and position themselves for uncorrelated returns. As the following analysis shows, there is a clear diversification benefit in having Liquid CTA/Macro Source: BarclayHedge, Bloomberg, L.P., Citi 100=January 1988 funds in an investor’s portfolio. portfolio. This left many participants overly exposed to equity Chart 6: CTAs Gain Market Share risk. In their desire to add investments to the portfolio that did from Hedge Funds not correlate to the major equity indices, many institutional investors (led by several high-profile endowments and foundations) began to increase their allocation to investment managers with a diversified approach uncorrelated to the major indices such as hedge funds and CTAs.

The long-term returns of CTAs have generally paced that of a diversified fixed-income portfolio consisting of U.S. Treasuries, mortgages and corporates as is shown in Chart 7. Along with that of the S&P500 total return index, the chart shows the performance histories of two CTA style indexes – systematic and discretionary – together with the Citi U.S. Broad-Investment Grade index (USBIG). For the period shown, large-cap stock returns (the S&P500) have outpaced those accrued by CTAs , but not without submitting investors to greater volatility and much larger drawdowns.

When returns offered by these asset classes over the same 23-year period are examined in light of the volatility they experienced, the picture shown in Chart 9 emerges. From 1988 through 2011, returns to CTAs lagged those of stock and Source: HFR & BarclayHedge bond portfolios when adjusted for volatility; however, the

underperformance is entirely a function of the period chosen. As noted previously, many institutional investors first began Ending the study at the end of 2008 would reveal that focusing on the Liquid CTA/Macro space as part of their CTAs performed quite well for each unit of volatility added, “portable alpha” push post the 2000 technology bubble. as can be seen in Chart 8. It is only in the past four years, Most investor portfolios at the time were heavily weighted with the recovery of the financial markets in the aftermath toward equities, with an 80% allocation to this asset class and of the subprime crisis, that strong equity gains have been 20% allocation to bonds representing the typical institutional accompanied by relatively low volatility in that market.

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 15 Chart 8: Efficient Frontier: Chart 9: Efficient Frontier: February 1988 – December 2008 February 1988-December 2011

Source: BarclayHedge, Bloomberg, L.P., Citi Source: BarclayHedge, Bloomberg, L.P., Citi

CTA outperformance during the turmoil that overtook equity During this longer-term time frame, the correlation coefficient and fixed income markets in late 2007 through early 2009 of returns between the Barclay BTOP50 index and a 60% was, and is, a strong argument for including managed futures stock/40% bond portfolio was -0.03. For shorter time frames, in a portfolio designed to withstand periods of extreme stress. correlations between CTA performance and the stock / bond This important feature of CTA performance is underscored portfolio can be greater. The trailing 5-year correlation in Chart 10, which shows the very low correlation between coefficients of monthly returns of CTAs vs. a 60% stock/40% returns of a “balanced” 60% stock / 40% bond portfolio over bond portfolio fall within +/- 0.4. the entire 23 years.

Chart 10: Trailing 5-Year Correlation Coefficients

Source: BarclayHedge, Bloomberg, L.P., Citi. 100=January 1988

16 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification “ There is no question that since 2000 the stock market has “ You have CTAs in the portfolio to even out the returns in had a rocky road. Investors have had no choice but to look at periods of market disruptions,” Alternatives. Literally. The one thing we constantly come up – $1.0b-$5.0b CTA against is that Global Macro and CTA have been swept up in “ We push our product as offering ‘crisis alpha’. We offer good that vortex,” performance during periods of equity downturns. We prove – $100-$500m Currency Hedge our value during an equity crisis and then when equities are “ We had a huge dip in 2008 in a lot of strategies and we lost a lot not in crisis, we can still offer a risk free 2% pretty steadily,”

of money but CTA/Macro did really well. We saw a big influx of – CTA-Focused Fund of Fund money into CTA/Macro as a result. It went up to nearly 50% of our book at one point, but now it’s come back down and moved toward fixed income,” – Fund of Fund with CTA/Macro Sleeve

Views Are Mixed on Whether Current Institutional Many of the interviewees pointed to the relative under- Interest Will Persist performance of CTAs post-2008 and the downturn in CTA performance in 2011 (-3.10% according to BarclayHedge The uptick in institutional interest witnessed post-2008 has CTA Index), and expressed concern that many institutional been greeted with some skepticism and concern by many investors may begin to sour on their allocations to these within the Liquid CTA/Macro space. They note that there is products. As noted above, CTA performance lagged those a history in the commodity markets of investors looking to of stock and bond portfolios when performance from make allocations to managed futures after a period of high 1988 - 2011 was considered, whereas that was not the case if performance, and that this is often exactly the wrong timing the examination period was limited to 1988-2008. for such investment. Others, however, see several shifts in the marketplace that may Commodity markets are often subject to “boom and bust” indicate that investors have now become more understanding cycles and periods of intense volatility. Many investors buying of how these types of allocations fit in their portfolios, and in at the top of that cycle are often dissatisfied with the that their commitment to the space may be long-lasting. subsequent performance of their managers and alarmed by the volatility these allocations contribute to their portfolio.

“ Generally investors stay away from CTAs and would rather “ There has been a huge migration of pensions into the CTA not be involved in them. They don’t understand them and space. The whole pension world has turned upside down since the pattern of CTA returns scare them—up and down, up 2008. The money coming from these investors has not been in and down, up and down and then some event or some trend long enough for us to know whether or not it’s sticky. Typically, occurs and they make money. Before 2008, investors only these investors would have just put their money into an S&P looked at CTAs after an event. CTAs are very cyclical and tracker and left it there,” grouped. The worst time to invest in CTAs is right after they - > $5B CTA made a lot of money. There is a long history of boom and bust cycles. Post-2008 people made the mistake of looking at CTAs like other parts of the portfolio that should work over time. They bought high into CTAs and that changed how they look at CTAs,” – $500-$1B CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 17 Investors have adopted a much more proactive stance toward educating themselves on the strategies they hold in “ Investors wait for these huge returns and by the time they their portfolio. Their previous “leave it to the professionals” get into CTAs, the move is overdone. Then they get stuck in a attitude was badly shaken by events such as the Bernard period of volatility,” Madoff scandal and by the unexpected assets many investors – Fund of Fund with a CTA/Macro Sleeve found themselves holding in their broader hedge fund portfolios toward the end of 2008/early 2009. “ The problem last year was the whipsaw choppy environment due to political intervention. People who had CTAs for tail As a result, they now look to fully vet the alternatives managers risk coverage expect CTAs to do well when things feel bad and they are considering for allocations and ensure that they have clear expectations on each manager’s style, expected returns last year things felt bad but a lot of CTAs struggled to even and volatility. Many survey participants felt that having stay afloat,” more clear expectations on how these investments should - > $5B CTA behave in different periods will result in investors maintaining allocations even during periods when they are not realizing strong returns.

Many Liquid CTA/Macro participants soliciting institutional money have also begun to adjust their own trading approach to better align to the desired profile of these investors. Most of the large CTAs and Macro participants interviewed for the survey with substantial institutional allocations note that they have significantly cut the volatility and expected returns on their portfolios. This helps with the “stickiness” of their allocations.

Regardless of how this debate plays out, it is important to remember that money has been flowing more rapidly into these investments than at any previous time, and there are currently record allocations held in Liquid CTA/Macro strategies. We will now look within this category and examine which strategies have been attracting the most interest in recent years.

“ We are putting more emphasis on developing institutional “ Clients are expecting communication to make them feel like products to provide them their desired risk adjusted comfortable and you have to make a lot of efforts around their returns whereas in the past, we were looking for more high education and helping them to understand how the fund is octane returns,” going to react, particularly in periods of high volatility. You – $1-$5B CTA have to make them feel confident for a long period of time. You’re not trying to build a relationship for 3 weeks or one “ Clients like the constrained drawdown profile we generate. month or one year. You have to really get them to think of the It makes us look like a pension product,” investment as performing over 3 years,” – $1-$5B CTA – $100-$500M CTA “ We’re an old fashioned CTA. We have higher volatility. Some “ We are currently under 10% volatility. Most of our competitors of the biggest CTAs in the market today used to have 17%-18% are running at 12-15%. When I started, we were aiming for volatility in 2005 and today they are down to 5%. That’s just under 20%,” 200-300 basis points over cash,” – >$5B CTA – $100-$500M CTA

18 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Section Two: Growing Sophistication of Systematic Trading Prompts Major Industry Realignment

For much of its early history, the Liquid CTA/Macro space was fairly evenly divided between discretionary and systematic trading approaches. This balance has shifted dramatically in favor of systematic programs in recent years as technology advances and the move away from floor-brokered to electronic execution has laid the foundation for more complex and sophisticated models that can screen markets dynamically and identify opportunities across a whole array of potential models and time horizons.

CTAs Break Down into Two Main Categories Discretionary and systematic funds occupy opposite ends of an axis characterized by the degree to which a portfolio A variety of trading approaches are used by CTAs in deploying manager is likely – or permitted by agreement -- to intervene client funds, but there are two main styles that characterize in the mechanics of a trading program. There are many the space. shades of grey between these two extremes, however. One group of participants use their understanding of market Most discretionary traders will use some of the market supply and demand and their interpretation of news and events measures followed by systematic traders to help them with to determine their trading approach. These CTAs are known their market timing. Many systematic traders will reserve an as discretionary traders. Many discretionary traders have option to override their trading signals if they perceive that a specialty area that relates to their personal backgrounds. there is something unusual about the market circumstances. Prior experiences either on the trading floors or within the One factor that investors typically press on in evaluating industry position these participants to offer unique insights systematic traders is the degree to which they are permitted and experience to gauge market activity and the impact to interpret their signals. of emerging news—political, economic or weather related. Specialization is a hallmark of the discretionary trader. They Systematic Trading Approaches Come to Dominate typically offer expertise in a specific market segment such as grains, energy, or livestock. Liquid CTA/Macro Strategies

The other category of traders in the CTA space measure A fairly even split between discretionary and systematic certain mathematical relationships within a market and build strategies was evident from 1980, when, according to systems with rules for establishing, adding to, reducing, or BarclayHedge, total industry assets were only $310 million exiting positions. They then use the signals generated by USD until 1999, when that AUM figure had increased more their system to inform their trading activity. As a result, these than 10x to approximately $40 billion USD. As shown in Chart CTAs are known as systematic traders. 11, discretionary traders held 45% of the industry’s assets in 1999 and systematic traders accounted for 55% of AUM.

There has been a massive realignment of the industry since “ Our strategy is a little bit of both. We have a systematic core that time, however. As shown, between 1999 and 2007 portfolio and we trade around that. Most CTAs are systematic systematic trading rose from 55% of total industry AUM to traders. They build systems to take their emotions out of it 67%. According to BarclayHedge, post-2008 those increases and they try to let the system work. We do that too in most accelerated and by the end of 2011, systematic trading systems products, but because I’m a discretionary trader as well, I accounted for 83% of the industry’s total assets. integrate our global macro picks on top of the system. I can overrule the system. We are far more proactive than most Three foundational changes in the industry have helped to systematic traders,” drive this shift. Foremost has been the growth in broadly – $1-$5B CTA available computing power and an increase in the ability of market participants to access market data electronically. “ I’ve been involved in global macro for over 30 years. I incorporate my economic perspective and my discretionary trading experience together with a quantitative application to develop an edge in screening and responding to changes in the market environment,” – $1-$5B CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 19 Between 1980 and the late 1990s, there was only very limited Chart 11: Dominance of Systematic Traders access to the technology and data required to create and in CTA AUM test a systematic trading program. The majority of Liquid CTA/Macro managers looking to create a systematic trading program needed to be affiliated with a major firm that possessed robust mainframe systems able to upload price data from major commodity and futures exchanges. They would then need access to professional developers to write query routines to generate signals and back test system results.

The explosion in Internet technologies in the late 1990s/early 2000s completely altered that paradigm. More and more data were becoming widely available on the Web, and tools to model and test such data were becoming commonplace. This made developing systems much more readily available to a broad pool of industry participants.

A second factor driving a surge in systematic compared with discretionary trading programs was the move away from floor trading in the commodity pits.

Many of the industry’s leading discretionary traders had emerged from the trading floors, where they had insights gained over years of watching specific markets and knowing the intricacies of the seasonal patterns, carry, and spreads in a specific market sector. Without the pits to breed these experts, there was less impetus for a trader to focus their attention solely on one market sector such as energy or grains Source: BarclayHedge or livestock or even the financial futures.

Once they became electronic, every market was equally The third factor driving the move away from discretionary accessible for study and testing, and the majority of toward systematic trading has been the concentration of participants found it more beneficial to look across markets for industry AUM with the largest Liquid CTA/Macro participants tradable patterns so that they had a broader opportunity set and the development of a tiered market structure. to examine. Indeed, one industry participant noted that this trend has gone so far that today “finding a good discretionary trader is like finding the Holy Grail.”

“ The currency side of our trading is largely systematic. Three-quarters of our trades are generated by the system. The remaining percent is discretionary where the portfolio managers try and do the smart thing and get in front of the flows or get in front of the model when there is going to be a big number or when they see a big order coming in in front of them. We want all the signals generated by our model executed by people. We just think of this as a common sense overlay,”

– $500M-$1B Currency Hedge Fund

20 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Generation One Trading Systems Track Simple Moving Averages “ Most of the discretionary managers out there have a heritage from the floor—the corn or the bond pits. The way they looked The first generation of systematic trading systems emerged at the markets was on the supply and demand. They took that broadly in the late 1960s/ early 1970s. These systems gained kind of knowledge off the floor and started their own money broad attention as their signals were able to produce highly management firms. A lot of traders today have never seen meaningful returns, helped by a period of strongly trending or been on the floor. They sit behind a computer screen and commodity markets. These trends were shaped by post-World that’s their entire exposure to the markets,” War II economic patterns which fueled sustained growth and rising inflation with accommodative monetary and – Third Party CTA Marketer fiscal policy.

“Most pensions are underwater and even at 7-8% growth, they There are two main characteristics to these early trend are in deficit. They are all scrambling to increase their returns. following systems as highlighted in Chart 12. These Generation Most pensions are not CALPERS or Ontario Teachers. They One systems were singular—one and only one system was are understaffed and have no idea so they turn to consultants used to generate a signal and the managers pursuing these and these consultants are not the highest paying jobs so they trades focused on a limited number of markets that were choose the safest, biggest funds. They want the names where predominantly found in the traditional commodity sectors. if something goes wrong, they won’t get blamed,”

– $500M-$1B CTA Chart 12: Evolution of Systematic Trading: Generation One

As noted previously, an influx of institutional money has been driving gains in AUM, particularly post-2008. These institutions typically rely on industry consultants to help them identify, evaluate, and select managers to receive their allocations. Consultants are known for their risk adversity. As has been widely noted in the hedge fund space, for alternative managers, many industry consultants equate “big” with “safe”. As a result, much of the money being directed toward Liquid CTA/Macro strategies has gone to the largest industry players, and the majority of these firms have developed systematic approaches because of their need to look across multiple markets to find sufficient opportunities to absorb increased capacity.

These factors changed the landscape and led to a more conducive environment for creating systematic trading programs. As these trends have unfolded, the sophistication and complexity of such systematic trading programs has grown exponentially. As a result, we see distinct “generations” Source: Citi Prime Finance & Futures of systematic traders operating in today’s markets.

Richard Donchian is known as the “father” of trend following and the originator of the first widely followed systematic trading program. He launched the first publicly managed futures fund, Futures, Inc., in 1949. Donchian’s focus was not on forecasting markets but on studying underlying price developments for signals on when to enter and exit a trade most successfully. Donchian joined Citi’s predecessor firm,

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 21 Hayden Stone, as the Director of Commodity Research in 1960 Buys, or the establishment of long positions, are signaled by the and began to publish a weekly newsletter for the firm’s clients, passage of the shorter-term moving average upward through where he listed the signals generated by his “system”. the longer-term average, and sells, or the establishment of short positions, are triggered when the shorter-term average descends through the longer-term average from above. “ New institutions entering the CTA space don’t chase the Practitioners have elaborated on moving average systems returns, they chase the assets. They’ll start by allocating to over the years, developing the Moving Average Convergence the big names. This way they gain a little more comfort,” Divergence (MACD) system as well as other schemes.

– $100-$500M CTA Strongly trending commodity markets in the 1970s offered particularly good trading opportunities, where reliable signals could be established for entering and exiting a position. Several factors were driving such trends, such as grain shortages Chart 13 illustrates the mechanics behind Donchian’s system and the OPEC oil crisis. There were also only a few other that looked at one-week and one-month moving averages – speculators in the markets looking at price movements in this corresponding to 5 and 20 trading sessions, respectively. manner. Most of the trading activity on the major commodity As shown, each day’s closing price is added together with exchanges of the time was between industry participants a set number of earlier closing prices. Five days’ closes are looking to hedge their physical requirements with liquidity averaged together to create the 5-day average and 20 days’ between sellers and buyers facilitated by the professional closes are averaged together to create the 20-day average. floor traders. Some of the efficacy of trend-following systems The daily results are then plotted and over time they create began to fade as more and more participants piled on with two “moving averages” or smoothed lines—one for the 5-day this approach in later years. moving average and one for the 20-day moving average. Other factors also led to an evolution in the systematic trading approach.

Chart 13: Example of Generation One Systematic Trading

Source: Citi Prime Finance & Futures

22 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification “ There was a perfect confluence of factors in the early 1970s of “ The first generation of CTAs had breakout systems. You get people thinking about computers and data, rampant inflation on board and catch the trend. The volume of that speculation because of all the money we spent in Vietnam, grain shortages ruined the model. The amount of money using those in many areas of the world and the stock market being flat. approaches broke the pattern. Those that adapted expanded Commodity prices started to go up,” their markets, they didn’t change their models. It got them to

– Retired CTA & Managed Futures Pioneer survive and move on,” – CTA-Focused Fund of Funds “ Early systems were breakout systems—all trend-following. Trends exist and persist. Let’s design something to take “ We remain long-term and true to the initial vision of our advantage of them,” strategy. Other folks are looking at shorter time frames, but – Third Party CTA Marketer we are a long-term trend following system. We want to change with the industry, but also be true to our core product. We want to provide a certain amount of exposure in a certain way and let people fit us into their portfolio,” – $100-$500M CTA

Generation Two Trading Systems Vary Rather than just examining a market with one system that Approach and Time Horizon would only intermittently be generating a tradable signal, Generation Two managers were able to cycle markets through Financial futures markets began to emerge after the multiple systems in order to determine whether there was a decoupling of the U.S. dollar from the gold standard. This potential opportunity. This concept is illustrated in Chart 15. afforded investment managers opportunities to participate in futures markets in currencies, bonds, and, over time, Signal generation became phased. First, price activity in equity indices and then finally single stock futures. These a market would be examined through a filtering program markets came to maturity in the 1970s and 1980s, providing to determine what “type” of market the price pattern those looking to trade futures systematically a broader set of markets to consider. Chart 14: Evolution of Systematic Trading Chart 14 shows that the managers creating Generation Two Approaches: Generation Two systematic programs took advantage of this expanding landscape to broaden the number of markets against which they participated. This was an important evolution, as many of these newer systems were being created by those with an academic background rather than a futures background coming from the floors or the physical commodity industries.

As such, those creating these systems began to look beyond just trend following and price breakouts (which at their core were primarily related to the market’s fundamentals) and instead began to apply more mathematical models focused on different types of market patterns such as mean reversion, momentum, and countertrend signals. Looking at the markets in this way became increasingly important as more and more institutional players were coming into the Liquid CTA/ Macro space, and they were looking for less volatility. As the number of patterns they could identify within the market activity expanded, so too did the number of systems that could be applied.

Source: Citi Prime Finance & Futures

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 23 was pointing toward. Once a recognizable pattern was determined, then the appropriate system would be selected “ Between 2003 and 2007, 70% of our models were mean and signals generated. As additional price activity unfolded, reversion models. That hasn’t worked well in highly correlated the pattern and the model selection could shift from one markets. The answer wasn’t to throw out the models. The approach to another. answer was to add other models to add diversity. Now we have 22 models. That is a reflection of us evaluating the As the provision of market data improved in the early 2000s, Generation Two systems were able to look at increasingly market regime and picking the type of regime and applying smaller windows of time to identify patterns. Whereas initially the models that work in the right type of regime,” systems looked at daily price activity and patterns that would – $1B-$5B CTA be established based on the day’s high, low, and close, over time they were able to look at intraday patterns and thus generate increasingly short-term signals. opportunity set to look across for signal generation, coupled with the expansion in the number of markets themselves as The hallmark of these Generation Two systems is that they discussed previously, set the stage for the industry growth we became multisystem and multi-term. Having a much broader saw in the early and mid-2000s.

Chart 15: Example of Generation Two Trading System

Source: Citi Prime Finance & Futures

“ The inefficiencies that trend followers could take advantage of “ The next generation of systematic traders embraced the new became diminished and additional systems have come into the financial market sectors and embraced more systems. They space. By the early 2000s, CTAs were saying, ‘let’s put some started talking about multiple models, not just ‘the’ model. We counter-trend systems or some reversion systems in there to started seeing sequential, momentum, volatility, relative value, cut our volatility. We need to get rid of this reputation of being mean reversion,” gunslingers. We need to be more attractive for institutional – CTA-Focused Fund of Fund

players.’ This caused their profile to change. They started “ There is a constant dialog between our strategies and the going for mid-teen returns and high single digit volatility,” markets and our ability to respond whether it be volatility – Third Party CTA Marketer or structural changes. I’ve done this through many market environments. The key to success is survivability,”

– $1B-$5B CTA

24 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Generation Three Trading Systems Overlay Chart 16: Evolution of Systematic Trading Multiple Models Simultaneously Approaches: Generation Three As more and more money flowed into systematic trading programs, there was yet another evolution beyond the Generation Two approach. The impetus to identify as many usable patterns – and profits – from the price action of a single market as possible has led in recent years to the emergence of multi-tiered trading systems, as illustrated in Chart 16.

These Generation Three systems layer several trading models onto a single market and run these models simultaneously. Signal generating systems are surrounded by different types of models. As with Generation Two, there are filtering programs that determine the type of signal generating system to apply based on the identified market pattern, but there are also transition monitoring programs that scan for a different set of patterns that may indicate an earlier pattern is ending. These transition scanning programs can turn off certain models just as the pattern recognition systems can turn on certain systems.

Source: Citi Prime Finance & Futures “ The third generation of models have this market environment identification component. There are at least 2 layers of models. This is all research driven. Research intensive. monitoring system may be applied. This process is ongoing, There are more white lab coats at these shops. More PHD’s. and there can often by as many as 20-30 models running These guys are doing really interesting stuff. What do you do simultaneously in a single market. with this thing called price? Can we price T-bonds in terms of There are two ways in which Generation Three systems handle gold? Corn in terms of T-bonds? ,” the multi-tier nature of their approach. In the first, the signals – CTA-Focused Fund of Fund being generated by the various models are netted. If the “ Everything we do is portfolio based. We’re running 25 models first signal generated is a long position and the next overlay system also indicates a long position, the manager would end against 65-80 markets per model. We pretty much run up holding two long position units for that market. If a third our models once a day and that gives us an opportunity to signal generated is short, the two long position indicators rationalize and net down models,” and the short position indicator would be netted and the – $1-$5B CTA manager would reduce their overall exposure to only one long position unit.

Chart 17 attempts to illustrate the workings of a Generation In contrast, there can also be a risk “budget” approach used, Three model. As shown, the filtering programs identify a where the money in the master fund would be parceled out tradable market pattern and initiate a signal-generating to different models. In this approach, each signal would have system. Once the trading signal has been initiated, the a separate pool of AUM assigned to it and it would trade transition monitoring program takes over and is constantly according to its unique signal generation. Using the example reassessing whether the original pattern is still in effect. As above, instead of netting the two long signals and the short additional market activity unfolds, the pattern recognition signal, the system may initiate 3 separate positions—two long systems may pick up an additional pattern and start another and one short and track each trade independently as if they system with a different signal generation approach and once were separate accounts. that system is turned on, a different type of transition

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 25 Chart 17: Example of Generation Three Systematic Trading Program

Source: Citi Prime Finance & Futures

One interesting facet of these Generation Three models is the highly diverse nature of the patterns they scan. Most of the “ You have to have a robust portfolio of systems that are pattern recognition used in Generation Two systems referred apropos to the current market environment. This allows to open-high-low-close related price patterns (regardless of us to have dynamic allocation. We have a correlation index the time interval being examined). Generation Three systems that tells us how trending the markets we are looking at are. will often look to recast prices in other measures (such as Longer-term strategies are good for some markets. Shorter- recalculating bond market prices in their equivalent gold term strategies are good for volatile markets. In 2008, we value as opposed to USD or EUR), they can look for other put in an intraday program that added a valuable edge on our patterns such as the gap between bid-offer spreads, or they time horizon,” can identify “equivalency” markets where signals in one – $100-$500M CTA market will prompt them to initiate trades in another market.

The primary factor to remember about Generation Three funds “ We have filtering models that we use as a trend detection is that they are applying multiple models in a simultaneous mechanism. Then we’ll apply a trend strength qualifier time frame to the same market. to evaluate the accuracy of the trend signal and to decide whether or not to accept the signal. If we accept the signal, we run a sectors model that tells us what other sectors are likely to be acting similarly given the market conditions. Then we look at a technical timing model that gives us a “go or wait” indicator in terms of releasing orders,”

– $100-$500M CTA

26 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Evolution in Systematic Approaches Underscores the Importance of Constant Research “ Short-term systematic traders have much more complex models. They might have physics professors from Harvard Evolution in the design of systematic trading programs can on their team,” be directly attributed to the depth of importance placed – Fund of Fund with CTA/Macro Sleeve on research in Liquid CTA/Macro strategies. Many of the interviewees indicated that their research teams often made “ We’ve ramped up our expense base in terms of research and up 50% or more of their total staff. Several participants now we are trying to raise our AUM to catch up with it,” referred to these individuals as the “white coats” in deference to their academic pedigree. Research is critical to these – $500M-$1B Currency Hedge Fund strategies for several reasons.

As noted with the early trend-following models, there can often Another reason is that to keep expanding capacity, managers be a piling-on effect evident with systematic programs. This need to constantly be testing their models and assumptions occurs when one type of system becomes broadly adopted against new markets, and monitoring to see how deep the and many different managers are having signals generated liquidity pool in a new market must be for their system to work against similar patterns at similar times. This makes it harder optimally. Expansion in the number of markets is equally as for any one manager to benefit from the signal, and it can important to the later generation of systematic traders as the often work to dampen the efficacy of signal generation overall. type of system they design. As a result, managers must be constantly looking for patterns that others are not already following so that they can have a Finally, there is an opportunity for innovation in research as unique view into their opportunity. the body of knowledge about price behavior improves and better execution tools emerge. One of the managers we interviewed for the survey discussed how their systematic “ We are actively engaged in research. We focus on pattern approach is focused on such a short time horizon that they recognition. We have a number of PHD’s that look at past can actually be said to be providing liquidity between price patterns of prices looking for patterns in the noise. We try to ticks in the market. keep our research department at close to 50% of our people,”

– >$5B CTA

“ We’re always involved in ongoing research and development. We’re always looking at other asset classes. If we want to grow, we need to prepare. We need to have everything ready to go,”

– $1-$5B CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 27 Chart 18: Timeline of Shift to Electronic Trading

Source: Citi Prime Finance & Futures

Emergence of Electronic Execution and the floor broker would have to go back to the phones Direct Access Facilitate New Strategies and relay back to the trend follower that their order had been completed. The move from floor-based to electronic execution has also been an important driver of the layered Generation Three Acting on a short-term signal would have been nearly and dynamic Generation Two systematic trading approaches. impossible in these circumstances. In contrast, today’s As shown in Chart 18, the trend toward having electronic as systematic programs are often co-located on servers in opposed to floor-based trading pits began in 1984 and by 1998 remote data centers alongside the exchange’s own servers. the major commodity and futures exchanges had shifted to an Tick level price data can be scanned by these programs in electronic execution approach. near real time or algorithms can be applied that normalize the release of orders based on a certain rules and when a signal Early trend followers were required to phone up their floor is generated, orders are compiled and submitted mechanically brokers to place orders. Their ability to get an order executed via FIX protocols directly into the broker or exchange queues. depended in part on how busy the pits were and how many other clients were calling in to get orders executed at the same The move to electronic markets has been as important time. Once they got through and placed their order, the trend a contributor to the emergence of more sophisticated followers needed to wait for their floor broker to announce systematic trading as improved modeling capabilities and their desired buy or sell level to the other traders in the broader availability of data realized through the emergence pit via open outcry. Then the floor broker would wait to of Internet technologies. Without this enhancement, there have their order matched by the pit managers and recognized would not have been an opportunity to develop so many by the exchange representative. Once that “fill” had occurred, varied and short-term trading approaches.

“ There has been an electronic trading revolution in the markets. “ One of the biggest changes in how we do business is the When I started, everything was being done over the phones. It move to electronic trading. We need to have speed and an could take minutes, hours or even days to get a trade off. Now infrastructure to support it. This is what gives us the ability to this is done via algorithms which are rule-based and gives you stage our orders. 80% of our alpha comes from trend following, more regular results,” but we have some short-term trade overlays on top of that. We – $1-$5B CTA were one of the first on electronic platforms and are currently almost 100% electronic. Right now, from signal generation “ We had over 20 some traders when I started interacting with the to generating orders to having them waiting at the brokers markets. They were calling the FX dealers, calling the traders in happens seamlessly. As a business, electronic execution has the pit. Over time, we changed over to transact electronically in made things smoother and easier and more efficient. You don’t the markets. It was a slow transition. We started making heavy get the breaks you used to get with the floor brokers,” investments about 2-3 years ago. Now we’re down to 6 traders and 97% of their activity is monitoring our FIX flow,” $500M-$1B CTA

– $1-$5B CTA

28 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Complexity of Systematic Approaches Challenge When an investor is uncertain about how the model works, and Concern Investors they often lack conviction on how that manager would perform in unusual market circumstances. Looking at performance While evolution in the systematic Liquid CTA/Macro space has in past periods of market stress is not always illustrative. been impressive, the increasing sophistication and complexity Many survey participants expressed concern that CTAs’ of many of the latter generation systems has elicited concerns commitment to ongoing research means that the models and from many in the investor community. These concerns typically approach used in past periods may not be providing an apples- fall into two categories – whether investors really understand to-apples comparison to how the current models and the set the manager’s approach sufficiently to evaluate the manager of markets against which they are running would perform in adequately, and whether the addition of ever larger numbers similar circumstances. of models is actually contributing to performance. Intuitively, investors also expressed concerns about whether The first concern is the outcome of CTAs bringing in academic the increased trend toward layering systems is actually PHDs to create models. These intellectuals are trained in achieving positive results. This is a particular concern with the mathematical concepts that range far beyond most investors’ Generation Three systematic approaches, as these managers understanding of market theory. Explaining how the models are applying multiple models to the same market at the same work can be very challenging, and many investors noted that time. Investors worry at what point diversification crosses they walk away with only a high-level understanding of the over into “de-worsification”. manager’s approach.

“ The understanding of how these systems work exceed most “ You’ve got a lot of really popular managers now that layer investor’s abilities beyond having a broad brush understanding,” their models. This one plus that one plus another one. Some

– Third Party CTA Marketer may have 100 models they’re running. You have to watch out for conflicting indicators. When managers over diversify, the “ For the Gen 1 guys, it would take me 1.5 hours to understand models might end up doing nothing,” their process. For these Gen 3 guys it can take days and you – Fund of Fund with CTA/Macro Sleeve have to sign NDA’s,” – CTA-Focused Fund of Fund “ There are some concerns emerging. If you have 10 different systems going on in one market, you could have long positions “ We may like the portfolio manager and like the head of the firm in some systems and shorts in others and your net exposure to and like their performance and the systems, but how do you the market may be much smaller and you’ll see your returns evaluate what to expect when something outside what they’d dampened by de-worsification. Too many systems in place statistically expect to see in the model happens? How do they could be a big problem,” anticipate that and adjust for it? That’s why it’s hard to evaluate – Third Party Marketer these managers, because you look at their 15-year track record and it looks pretty good but you don’t know what the models looked like back then and you don’t know the markets they were in and how they have changed,”

– Fund of Fund with CTA/Macro Sleeve

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 29 Section Three: Layered Distribution Approaches OfferMethodology Diversified Options for Accessing Capital

Liquid CTA/Macro product appeals to a broad range of investor types. Because of its regulated nature, broker-dealers have long pushed managed fund product to their retail clientele via their financial advisors network. Post-2000, the industry has also attracted significant flows of institutional capital, and new platforms have emerged to target this audience. Finally, many CTA/Macro participants view themselves as part of the hedge fund space, particularly in Europe, and thus look to follow that industry’s model by marketing their product directly to end investors. The result has been a multilayer distribution approach. Additional channels are also emerging via regulated fund structures such as ETFs, 40 Act alternative funds, and UCITS funds.

Retail Roots of the Industry managers considered emerging industry leaders to manage their portfolios. Many of these managers came from a firm High net worth and retail participants were the first called Commodities Corporation. noncommercial audience to invest broadly in the Liquid CTA/ Macro space. Such investments were realized through a set Commodities Corporation has a rich history and possesses of managed futures products created and distributed by the a unique role in the Liquid CTA/Macro and overall hedge brokerage or wire houses in the 1970s/early 1980s. fund space. The firm was co-founded by a set of commodity experts and academics including Hayden Stone alumni Widely publicized bull markets in many core commodity Amos Hostetter, Nabisco alumni Helmut Weymar and Frank products ignited the imagination of retail and high net worth Vannerson, the economist Paul Samuelson, and MIT professor investors. Brokerage houses at the time were encouraging Paul Cootner. diversification in investor portfolios using a concept called the “risk pyramid”. This approach encouraged investors to parcel Many successful traders were affiliated with Commodity their investment capital out in a pyramid structure based on Corporation, including several well-known traders who were the likely risk-reward ratio of the products at each level of the among the first generation of managers hired for the wire pyramid. houses’ managed futures product. Such traders included Paul Tudor Jones (who then went on to form Tudor Investment The base of the pyramid was supposed to be low-risk Corporation), Bruce Kovner (who went on to form Caxton instruments with limited returns such as government bonds, Associates), Louis Bacon (who went on to form Moore Capital CDs, and money market funds. The middle of the pyramid Management), Bill Eckhardt (who went on to form Eckhardt contained slightly riskier assets such as real estate, mutual Trading Company), and other luminaries of the time including funds, and individual securities slated to generate slightly Michael Marcus, Jack Schwager, and Ed Seykota. more aggressive returns. The top of the pyramid were the riskiest assets that would produce the highest reward. Another manager chosen for the early managed futures Managed futures fell into this final category, and they were products was a highly successful floor trader named Richard seen as offering “high octane” returns in exchange for high Dennis, who had created his own unique breakout system that risk. pyramided positions. Richard Dennis was also the mentor and sponsor of a group of traders known as the “turtles”. To settle In some instances, such as with Citi’s predecessor firm a debate he was having with Bill Eckhardt about whether or Shearson Lehman Brothers (the successor firm to Hayden not trading skills could be taught, Richard Dennis recruited Stone), the talent around which to create a managed futures a group of 21 individuals, taught them his trading approach, product was found internally. As we mentioned earlier, Dick and staked them each with $1.0 million of his own money. His Donchian was the Director of Commodities Research and he experiment ran from 1983-1988. During that period, the group had established the industry’s first managed futures fund turned Dennis’ $21 million into $175 million. Graduates of the earlier in his career. He and his team were able to build turtle program include Jerry Parker from Chesapeake Capital, dedicated managed futures product and distribute those Tom Shanks from Hawksbill, and Elizabeth Cheval from EMC. funds via the organizations’ financial advisor network. Chart 19 illustrates the model used for creating and distributing Other wire houses were also active in creating and distributing retail focused managed futures products. managed futures product. Many of these firms hired outside

30 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Section Three: Layered Distribution Approaches Offer Diversified Options for Accessing Capital

Chart 19: Retail Managed Futures Distribution Model

Source: Citi Prime Finance & Futures

After signing the manager, the wire houses would then of the fund’s assets) and an incentive for managing the fund structure the terms of the investment fund. There were successfully (20.0% of the net profits generated by the fund). multiple layers of fees built into these products. First, there Many view the structuring of these early managed futures were the fees paid to the manager running the fund. Typically, products as the model for the 2 and 20 arrangements later these included a fee for managing the money (set at 2.0% adopted by the hedge fund industry and which remains the norm for those managers to the present day.

After the manager’s fees were determined, the futures “ Back in the 1980s it was all about the risk pyramid and division at the wire house sponsoring the fund would build diversification. After you invested in your stocks and your in a general partner fee to cover their execution and clearing bonds and your real estate, managed futures were where expenses. Finally, the financial advisor or private banker you invested your riskiest assets. We preached it and we distributing the fund would layer on their own up-front fee believed it,” for placing the investor into the product. The all-in package – Retired CTA & Managed Futures Pioneer of fees on these products were extremely high, sometimes as much as 6% of assets and 20% of profits, but retail investors “ 20% of our distribution is done via outside managers that on- would absorb these costs because the returns, particularly in sell our products to their retail investors. These distributors the early years of their introduction, were so lucrative. The typically tack on additional fees—most often upfront fees. BarclayHedge CTA index showed an average return for 1980- People often have to pay 3-4% just to get into the product. 1989 of 24.7%. For large clients, we might take our fees down a little from the 2&20 we charge to make the overall package more attractive for them,”

– $500M-$1B CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 31 Rising Institutionalization Prompts a The industry norm in the managed futures arena was, and for New Distribution Model the most part still is, to open a segregated customer account for each investor in the fund. Thus, every time an institution As institutional investors began to show more interest in the would sign on with a fund of fund, the fund of fund would Liquid CTA/Macro space, the industry’s original managed need to open a new segregated account in the investor’s name futures distribution model proved untenable for this with the underlying Liquid CTA/Macro manager. Without a audience. High fees associated with these retail managed platform to handle this operational burden, the influx of futures products were prohibitive to the institutional accounts could quickly become overwhelming for both the audience. Institutional investors were also not positioned to fund of fund manager and the Liquid CTA/Macro manager. directly approach managers because they (and many of the consultants that supported them) lacked familiarity about This led to the emergence of a new platform called which managers to evaluate and they were ill-prepared to AlphaMetrix in the mid-2000s. Drawing on the managed perform due diligence on such managers. Many allocators account platform model in the hedge fund industry, the instead turned to fund of funds that specialized in the Liquid original goal of this platform was to be a facility for allocators CTA/Macro space. to simplify the operational handling of their investments. The platform would allow them to bundle the money coming in Increased allocations to fund of funds created operational for a specific manager and establish the platform as a single issues for many of the Liquid CTA/Macro managers. face-off to that manager rather than having to pass Regardless of whether the institutional investor would place each individual account onto the manager to be handled as a money into the fund of fund’s co-mingled vehicle or if they segregated customer account. wanted to establish their own segregated account, there were very few Liquid CTA/Macro managers on the other side of the allocation that were set up with a co-mingled fund.

“ The only channel in the 1980s and 1990s was the wire house “ Commodities traders had always been viewed as gunslingers, managed fund platform. We’d build a strategy, set up a separate especially in the beginning. It was a gambling stake. People account and they’d go out to their vast sales force to raise would put $50,000 in and expect to double or triple it or money. We still have a lot of high net worth money from those blow it all,” sources,” – Third Party CTA Marketer – $500M-$1B CTA

“ Our investor base is 99% retail due to our affiliation with a wire house. Most of our clients are going to be on the smaller side—the lawyer, the doctor, the retiree—each looking to put in $200,000 to $300,000,”

– $100-$500M CTA

32 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification In the new model, the platform itself would handle the segregation and subaccounting of the individual investor “ One of the reasons we are doing the joint ventures with the funds. What quickly became evident was that once managers platforms is that we didn’t see a change in the clients we were set up on the platform, it became much easier to have. We still had clients from the old wire houses where allow investors to look through to the underlying managers we got our start. The majority of clients on the distribution and create their own custom portfolios, since all of the platforms were institutional and non-U.S.,” managers on the platform had already been vetted from a – $500M-$1B CTA due diligence perspective and information on their style, returns, and volatility could be accessed via simple filtering “ Small fund of funds are using the platforms for liquidity,” tools. AlphaMetrix initiated a new business model that – $500M-$1B Currency Hedge Fund allowed institutional investors direct access to Liquid CTA/ Macro managers.

Meanwhile, the brokerage houses that had long been active We have opted to call this distribution model the “shopping in the managed futures arena were looking for new product mall” because of the way that institutional investors were able opportunities to capture an increasingly institutional audience. to use the platform. Institutional investors could go on to the Deutsche Bank launched a variation on the AlphaMetrix platform and browse a broad selection of managers. They platform in the mid-2000s called dbSelect. Their model was could then narrow their set of choices by using filtering tools slightly different in that instead of opening a segregated built into the platform. Once they had determined which customer account for each investor, they would provide managers they wished to invest in, they could direct funds to access to the underlying managers on the platform via a swap the platform and the platform provider would then channel construct that delivered the indexed returns of the manager. those funds to the underlying managers.

The dynamics of these platforms are highlighted in Chart 20. In the AlphaMetrix model, the investor’s money would go directly into a subadvised platform fund set up for each manager on the platform. In the dbSelect model, the investor “ Distribution platforms have been a major source of growth would set up an ISDA agreement with dbSelect and then fund a swap with Deutsche Bank. This swap would guarantee for the industry, especially for certain segments. Some the investor the monthly returns of an index that mirrored institutional investors will only access managers via a the performance of that manager’s subadvised fund on the platform. They’ve done the due diligence and eliminated as dbSelect platform. Meanwhile, Deutsche Bank would fund the many risks of the manager as can be eliminated,” manager’s account in proportion to the swap value and face – Third Party CTA Marketer off to the manager as their counterparty.

“ For certain managers, being on a platform really helps In both models, the investors would then have access to because you can aggregate a lot of smaller tickets. It’s really reports that summarized the manager’s activity and their good for a manager on the smaller side,” account status.

– CTA-Focused Fund of Fund

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 33 Chart 20: Evolution of Institutional Distribution Platforms: Shopping Mall

Source: Citi Prime Finance & Futures

Managers Seize on Opportunities with For managers outside the United States, there is also a Institutional Platforms secondary benefit. Since managers listed on a platform are not actively marketing their funds, they do not need to In recent years, other brokerage houses have launched similar register as a CTA with the CFTC. Thus, the platforms offer an platforms and many Liquid CTA/Macro managers are looking opportunity to many foreign firms to access U.S. investors, but to list their funds. Although there are high costs for joining at arm’s length so that they do not carry the accompanying such platforms, interviewees noted that being listed in these regulatory burden. venues has become a part of their marketing and promotional efforts. There is a sense that these platforms help get their There are, however, other issues that have emerged regarding names out in front of many institutions who might otherwise the distribution platforms, particularly these early “shopping not have seen their information. mall” models.

“ The nice thing about platforms is that everyone is seeing your “ We feel that there is more regulation coming and we don’t name and performance. It’s almost an advertising tool or a see much harmonization. In the short-term, for European great marketing tool,” managers it’s hard to have US clients, at least directly. It’s – $1-$5B CTA more difficult to talk to investors directly because you would need SEC registration. This is why we are happy to be on the “ We are launching a US product off one of the platforms. We’ll platforms. We don’t need to be registered because there is no be using their registrations,” direct contact,” – CTA-Focused Fund of Funds – >$5B Currency Hedge Fund

34 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Issues Emerge with Original “Shopping Mall” Platforms “ If I’m an unknowledgeable investor and I get this long list There are three main areas of concern interviewees cited of managers and I don’t know who to pick, I’ll end up losing in discussing the early wave of institutional distribution money. You need people to translate these choices,” platforms. Foremost, both investors and managers noted that – <$100M Currency Hedge Fund the fees charged by the platforms could be prohibitive, either because the all-in price to the institution was too high or “ We haven’t had much success with these platforms raising any because the platforms required the underlying managers to money for us at all. It’s been pretty disappointing. We haven’t cut their own fees by too much in order to leave the platform seen any significant flows from these things and they’re provider room to charge their fees. selling themselves on the analytics, especially the ones not In some early incarnations, platforms were opaque about affiliated with a bank. These platforms are also misleading their fee structure and in some instances were actually when they report their AUM. They have 3 managers with charging an additional 1% management fee and 10% incentive 98% of the AUM and 100 managers with $0,” fee over and above the 2% and 20% being charged by the actual Liquid CTA/Macro manager. This mirrored the fund – $500M-$1B Currency Hedge Fund of fund fee structure, but unlike the fund of funds where the pool manager would be responsible for selecting the optimal set of individual managers, the institutional platforms were The second issue that became clear was that institutional leaving it to the investor themselves to choose the manager. investors were uncomfortable picking managers themselves While fees have come down, by some reports the platforms via the platforms, even with a full set of filtering and modeling still charge as many as 75 basis points against AUM directed tools to support them. While the platforms offered the means via their offering. These fees need to be factored against the to construct a portfolio, they did not offer the expertise underlying manager’s performance. required by the institutions to create an adequately diversified portfolio. Many institutions were not confident about their selections, particularly if the manager under consideration “ Hedge funds charge 2&20 and fund of funds would whack on was on the smaller side. As a result, many simply chose to 1&10 on top of that so that they were charging 3&30. Many put money with the largest managers on the platform figuring fund of funds have had to rethink that model. They are being those bets to be the safest. a little less greedy and working harder for their money,” The result of this pattern has been a highly disproportionate – >$5B CTA allocation of AUM moving through the platforms. Several interviewees noted that the AUM figures cited by the platforms “ We charge only 1 and 20 to leave wiggle room for distributors were highly misleading because the majority of AUM went to to add their charges,” only a small handful of managers, and that the majority of – >$5B CTA managers listed on the platform saw little to no flow. This “ We’re also on (a bank’s CTA) platform. We’ve been on the was very problematic for some managers, particularly smaller managers that had struggled to come up with the listing fee, platform for less than 6 months. So far, we haven’t had good which reportedly could be as high as $250,000 for each fund. performance in terms of finding capital,”

– $100-$500m CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 35 New Platform Models Emerge that Chart 21: Evolution of Institutional Deliver Expert Advice Distribution Platforms Since the mid-2000s, the distribution platforms have undergone an important evolution in approach. These changes are highlighted in Chart 21.

As shown, two new models have emerged. Both of these models address the need for an expert-driven level of advice that shapes an investor’s choice of managers. Where the two new models differ is on whether the advice is focused on offering the investor a customized or a standardized portfolio.

The new Customized Pools model provides a different course for those investors looking to shape a portfolio around their specific goals. This model is primarily being offered by fund of funds to their institutional and family office clientele.

In the Customized Pools approach, the fund of fund or pool manager works exclusively with the investor to understand their goals. They then identify a set of Liquid CTA/Macro managers that will satisfy these objectives. Once this set Source: Citi Prime Finance & Futures of managers is selected, the platform is used to create a

“fund of one” structure. These funds of one have become The customized fund of one is managed via the platform, and quite popular post-2008 because they offer an investor the the investors can capitalize their accounts and view reports on benefits of a co-mingled fund, but they avoid any contagion risk activity via the platform. These interactions are highlighted in from co-investors. Chart 22.

Chart 22: Customized Pool Institutional Distribution Model

Source: Citi Prime Finance & Futures

36 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Fund of fund managers focused on the CTA space are moving The platform operator then recreates the index as an increasingly toward this model. Having the platform to offer investable instrument and writes total return swaps for such a service is seen as a real differentiator. One point of investors interested in having exposure to that index as a concern with this model, however, was that the fund of fund hedge or investment vehicle. These swaps have a delta of one, is hard pressed to show a track record for the custom fund, which means that they exactly match the performance of the and many investors are hesitant to use the track record of underlying index. By having the investment in a swap vehicle, the co-mingled vehicle as a stand-in since the composition of the platform operator can adjust the index components in line managers may differ significantly. with changes from the index provider without having to rewrite the swaps or rebalance their investor accounts. Investors are By contrast, the other new model emerging in the market is only receiving the return stream, not the underlying exposure a platform that offers investors a standardized, expert-driven to each manager. portfolio, typically linked to one of the recognized industry indices such as the BarclayHedge Top 50 CTA Index (BTOP50) Investable indices are just beginning to emerge in the Liquid or the Parker Global FX index. These models are highlighted CTA/Macro space. Citi has launched our own platform using in Chart 23. this model, called Citi Access. Both investors and managers have high hopes for these products. In many ways, these In these models, an external agency unaffiliated with the indices are seen as representing an ideal institutional vehicle. platform provider, like BarclayHedge or Parker Global, picks The underlying investor can obtain exposure to a leading a set of managers that correspond to their index universe set of managers, but without having to select that set of and informs the platform operator which Liquid CTA/Macro managers on their own and without having to pay excess fees funds make up that pool and in what proportion. The platform to a market expert to select managers on their behalf. manager then sets up subadvised funds on the platform for each of these managers and stakes those investments in the same proportion as their index weight. This allows the platform to capture the performance of the underlying managers within their own environment.

Chart 23: Investable Indices Institutional Distribution Model

Source: Citi Prime Finance & Futures

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 37 “ Platforms have to play a role in fund of funds. In 2005, it was “The new index platform model offers two important things. An possible to just form a fund of fund without a platform. You independent allocator is selecting the managers and the bank were just passing on expertise and access. Now, if you can’t get is watching the assets. That’s two levels of protection for the access via a platform, that model’s dead. Now fund of funds investor. Also, the banks are putting their own money in. The really need to be able to customize portfolios to your taste,” idea of co-investing with a major bank is quite persuasive. I

– CTA-Focused Fund of Fund know that the rule changes post 2008 make that hard, but it is still very comforting,” “ US Pensions, particularly state funds, prefer to deal with fund – $100-$500M Currency Hedge Fund of funds. They are getting these fund of funds to create custom holdings for them,” “ Indexes are very powerful to institutional investors. With an – >$5B CTA index, they say all this past performance is pro forma and they’re okay with that because it’s an index. Whereas it’s “ You tell me what growth you want, what the exposures should harder to get people to buy into that for a multi-manager be, what volatility you want and then I’ll put a custom portfolio portfolio track record,” together for you. With a platform to use, I can set it up for as – CTA-Focused Fund of Fund little as $10 million,” – $100-$500M CTA

Largest Managers Build Out Direct, Chart 24: Direct Marketing & Hedge Fund-Like Marketing Capabilities Distribution Approach Because of regulatory distinctions, U.S. investors have traditionally seen hedge funds and CTAs as belonging to two different spheres. As a result, hedge funds’ and Liquid CTA/ Macro managers’ distribution and support evolved along separate paths.

The Liquid CTA/Macro distribution approaches were highlighted above. To recap, wire houses took the lead originally in distributing managed fund product and since they were selling these products to retail participants, they developed and then standardized a model that required client funds to be segregated into individual accounts. The emergence of the institutional distribution platforms provided another route to market for U.S. CTAs/Macro managers; and in this model as well, clients maintained individual segregated accounts or accessed performance via swap. Source: Citi Prime Finance & Futures

This long tradition of separating and insuring client funds was In Europe, where a significant portion of today’s Liquid CTA/ one reason that the recent MF Global bankruptcy has been Macro traders can be found, there has not been the same so impactful. That firm’s alleged use of customer funds to perceived split between hedge funds and CTAs. In most cover the broker-dealers’ proprietary positions broke the European participants’ minds, CTA is a strategy within the foundational agreement between clients and managers in the hedge fund set of alternative investment approaches. As a U.S. market. result, European managers have aligned predominantly with For hedge funds trading in the U.S., there was a very different the hedge fund’s direct marketing and support model noted distribution and support model. This model aligns much in Chart 24. more closely with how the CTA model developed in Europe. With the increased institutional focus of recent years, larger This direct marketing and distribution model is highlighted U.S. mangers are also now beginning to adopt this approach. in Chart 24.

38 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification “ The downside of not having a co-mingled fund is that some “ We always have relied on segregated accounts. Even though investors only want that structure and I can’t attract that we had power of attorney over our accounts to trade, the money. Usually, it’s the large institutional investors looking accounts are still there for the client to see. They could close for that option and they probably wouldn’t give me money at it tomorrow if they want to. MF Global blew that away when this point anyway,” it looked like fraud. It hurt our industry pretty badly. The slow – <$100M CTA response of the exchanges and the slow disbursement of funds left us not looking very good as an industry,” “ To avoid tracking errors, we needed at least $70 million in a – $500M-$1B CTA separate account. Given that minimum, we are getting a lot of interest about going into our co-mingled fund,” “ One of the challenges of marketing your own product is that – <$1-$5B CTA you need to think about where to invest resources. There is tremendous wealth in the Middle East and Asia and you’d think that we’d see a big influx of this money, but we haven’t. There are several important differences in the direct, hedge Should we focus our efforts here or should we focus on North fund-like marketing approach. First, the manager will typically and South America and Switzerland? How should we deploy hire a marketing or investor relations professional to run their our marketing resources?” team and be charged with raising capital for the organization. – $500M-$1B Currency Hedge Fund Such individuals form direct relationships with pension funds, endowments and foundations, family offices and high net “ About 1/3 of our capital is in the general fund. This is where worth individuals. This differs from the models discussed pensions are coming--over 36% of that fund is pension money. earlier, where the fund manager would typically handle The other 2/3 of our capital is in futures managed accounts. marketing efforts and hold discussions with the brokerage Pensions prefer the general fund because the fees are houses, fund of funds, and platforms. It was these brokerage more attractive,” houses, fund of funds, and distribution platforms, not the – >$5B CTA managers, that had the direct investor relationships.

The second difference relates to the structure of the fund. charge investors the base 2% management fee and 20% As noted above, the earlier U.S. model had investors either incentive fee. Institutions that are willing to write large tickets putting money directly with an investor via a segregated can often access a different share class that offers them even account or accessing that manager’s performance via swap. lower fees in the co-mingled fund. Only fund of funds offered a co-mingled investment vehicle This ability to support co-mingled funds was possible because to the investor. In the hedge fund model, the Liquid CTA/ of the final difference. Liquid CTA/Macro managers that viewed Macro managers themselves create a co-mingled investment themselves as hedge funds would build out their own operational structure and allow investors to directly access this pool. Fund infrastructure and not rely on their distribution partners to handle of funds would invest in the managers’ co-mingled vehicle the operational aspects of their fund. While many U.S. CTAs spent alongside institutional and high net worth investors. money on infrastructure, the bulk of that spend was on research By allowing investors to go directly into a co-mingled vehicle, or execution, not operational support and reporting. With their Liquid CTA/Macro managers are able to eliminate the own trade reconciliation and portfolio management capabilities, “middleman” fees. At the most, these co-mingled vehicles CTAs operating like a hedge fund did not need to be affiliated with a broker-dealer or a distribution platform, and could directly “ We have regional sales teams who own the relationship with accept and manage investor funds. the investors. Their coverage is all institutional,” While the bulk of the capital in these firms would be directed – $5-$10B CTA to the co-mingled vehicle, these managers might be willing to accept capital via a separately managed account; however, this “ A CTA is much cheaper to manage than a hedge fund. I don’t would only be considered for extremely large allocations and not have a full-time operations person, mostly because I don’t as a standard practice. Moreover, the manager would typically see a need. Everything is automated in terms of reconciliation administer their own separately managed accounts or if they used with the providers and I don’t have to move cash. I don’t have a platform, that platform was likely to be sponsored by a different to deal with an administrator. It’s also cheaper to operate an set of providers that focused their offering on operational SMA instead of a co-mingled fund,” support, not capital raising and asset allocation services. – <$1-$5B CTA

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 39 Layered Distribution Becomes the Industry Norm “ My investors rely on their financial advisors and that’s it. In the past several years, particularly post-2008, the largest Most of my business is by referral,” U.S. and European managers are now typically running a mix – <$100M CTA of money, some in segregated customer accounts at a broker- dealer or on asset-raising platforms, some in separately “ We are now trying to branch out and target the institutional managed accounts which might be on different operational space. There is interest in systematic trading that we’ve never platforms, and some in co-mingled funds. seen before from pensions, sovereigns and endowments. As the CTA’s AUM grows, new distribution options are added, I never thought I’d see interest from them,” but, interestingly, the managers rarely choose to end any – $500M-$1B CTA distribution relationships. The result is a multilayered model for attracting assets. This is highlighted in Chart 25. “ If an investor can’t come up with the size we require to have a separate account, we push them to the platforms. We’ve added three distribution platforms in the past 2 years,” Chart 25: Multilayered Approach to Asset Raising – $1.0-$5B CTA

“ We’ve done a good job transitioning our portfolio to include more institutional investors. In 2008, our portfolio was 85% fund of funds. Now fund of funds are down to the mid-30% range,” – $1.0-$5B CTA

Having multiple paths to raise capital is a hallmark of the larger CTA/Macro managers, particularly those with a long history. Each distribution approach can be thought of as an attempt to access different investment audiences: Retail, High Net Worth, Emerging Institutional and Large Institutional.

Source: Citi Prime Finance & Futures Liquid CTA/Macro managers add new distribution channels each time they approach certain AUM thresholds.

Chart 25 shows that small managers with AUM of less than $100 million USD typically rely on financial advisor networks “ High net worth individuals tend to come through the wire to raise money for them from small retail clientele. As the houses. They don’t provide any due diligence. Just a point AUM moves above this $100 million USD mark, the manager of contact,” will start to pay up and make a marketing investment to have – $1-$5B CTA their fund listed on the institutional distribution platforms that could give them access to high net worth, family office, “ The only channel in the 1980s and 1990s was the wire house and emerging institutional interest. As a manager’s AUM managed fund platform. We’d build a strategy, set-up a surpasses $500 million to $1.0 billion USD, the manager will separate account and they’d go out to their vast sales force begin to build out their own direct marketing team and if they to raise money. We still have a lot of high net worth money had not done so before, they will also typically launch a co- from those sources,” mingled investment vehicle. – $500M-$1B CTA This Liquid CTA/Macro distribution model is quite unique. It “ High net worth platforms, managed account platforms and bridges two investment pools that are typically quite separate. mutual fund platforms are all distributing CTAs. It’s attractive Liquid CTA/Macro managers can effectively compete to us because of the diversification of the investors they offer,” for capital with traditional hedge fund managers, as the – $1-$5B CTA allocations targeted for both types of funds usually originate from an investor’s risk capital or alternatives bucket. Yet, CTAs are also a regulated product like mutual funds and long-only

40 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification funds that can be broadly marketed to a range of investors, Exchange Commission (SEC) whereas the traditional CTA including retail participants that are barred from participating product is regulated by a different body, the CFTC. in the hedge fund space. Many participants expressed concern that until there is This ability for CTAs to compete for retail allocations could guidance about how to harmonize these two regimes, there open a new marketing platform and add yet another source of could be too much uncertainty to warrant a full-blown effort to distribution for managers in the period ahead. structure and launch these newer types of funds, particularly from the large long-only or traditional asset managers that have traditionally dominated the mutual fund space.

“ We’re starting to see a lot of interest in the mutual fund By contrast, in Europe, UCITs regulated fund structures have products. Some people are hesitant to go down that road been around for several years, and are gaining significant because they’re not sure about the regulatory environment, traction in the Liquid CTA/Macro space. The goal of these but this could be a huge pool of money. In essence, it is regulated funds is to offer investors onshore funds that clearly retail investment into the Alternatives space disguised as a fall under the jurisdiction of European law. Many hedge funds mutual fund,” had previously been set up as off-shore accounts and in the – $500M-$1B CTA wake of the Madoff scandal, many investors found themselves with only limited if any protections. “ There’s growing interest from individuals in 40 Act funds. UCITS funds have very short-term liquidity requirements and The returns for the manager are less, but the ability to raise although there is spotty uptake by many hedge fund managers assets in this space is easier because people understand mutual that may be holding illiquid securities in their portfolios, Liquid funds more. The mythology of futures is that you can lose CTA/Macro participants find that their investment profile all your money and more. That lack of familiarity is limiting and product set aligns well with the structure. Traditional people’s interest, but when you wrap it in a mutual fund, investment management firms have also been active suddenly it’s all okay,” participants, expanding their long-only product lines to offer –<$100M CTA these UCITS vehicles.

Several of the industry’s largest Liquid CTA/Macro participants have raised billions of dollars via the UCITS forum in recent ETFs, Mutual Funds, and UCITS Are Seen as years, hinting at the possibilities that may lie ahead in the Potential Growth Areas U.S. marketplace

Interest in efficiently tapping into the retail space, with its smaller investment sizes, has led to the creation of several types of new regulated fund structures. “ It will be interesting to see what happens to fees with this 40 Act money. Rule 12B-1 on exposures limits what you can In the U.S., these new vehicles differ from traditional CTA raise on fees in a 40 Act fund. Nonetheless, retail is all the offerings in that they require investors to go directly into a pooled vehicle with publicly traded shares rather than into rage in the US for managed funds,” a segregated client account. Moreover, regulatory limits on – CTA-Focused Fund of Fund the amount of fees that can be charged on these investments “ We’ve had a lot of success with UCITS funds. We’ve raised more force managers opening such funds to abandon their than $1.5 billion Euros through a large UCITS fund structured traditional fee arrangements and instead agree to a flat basis by a bank,” point management fee. Emerging structures in this category – >$5B CTA include Exchange Traded Funds (ETFs), Exchange Traded Certificates (ETCs) mutual funds and mutual fund of funds set up under the terms of the Investment Act of 1940, also known as “40 Act” alternative funds.

Expectations are that these new vehicles will draw substantial interest, but there is one impediment holding many participants back from exploring the new structures. All of these emerging products are regulated by the Securities

Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification I 41 ConclusionMethodology

From their original position atop the retail and high net worth investor’s “risk pyramid”, the Liquid CTA/Macro industry has broadened out and become a core portfolio component for institutional investors of all flavors in recent years—from public and corporate pensions to endowments and foundations to family offices.

Positive, uncorrelated performance during the 2008 Global All of these factors are working to move Liquid CTA/Macro Financial Crisis helped accelerate this expansion in the managers into the mainstream. Prospects for continued industry’s investor base. Yet, the industry itself also changed asset growth are good and the rising level of institutional to accommodate this new institutional base. interest may soon be matched by a new wave of retail interest via products emerging in the regulated fund space including To absorb the extensive asset flows originating from ETFs, 40 Act alternative funds, and UCITS funds. institutions, the industry sought means to extend its capacity and reduce portfolio volatility. Citi Futures & Prime Finance are committed to supporting this growth. This report marks just one facet of a multipronged As the audience base has grown, the distribution model too approach we have underway to improve our platform and has evolved. Whereas money was primarily raised for these position ourselves as a trusted advisor and partner to both managers by wire house financial advisors via managed our CTA clients and investors focused on this space. futures product in the early years of the industry, we are now seeing managers list their funds on institutionally focused capital raising platforms and develop their own hedge fund-like marketing teams to directly raise assets.

42 I Moving Into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification Conclusion

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